Levitt on the Street

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Arthur Levitt knows what it’s like to be in the hot seat. As the former chairman of the Securities and Exchange Commission and an outspoken advocate for investors, Levitt fought, and lost, the politically charged battle to separate accounting firms’ audit and consulting arms in the 1990s. Now, in the wake of recent corporate accounting scandals, Levitt reflects on the challenges the commission’s new chairman, William Donaldson, will face. HBR’s Ben Gerson recently spoke with Levitt about the conflicts of interest that have eroded investors’ confidence, and the steps the SEC, Wall Street, and corporate boards must take to restore their trust. Levitt, who led the SEC from 1993 to 2001, is the author of Take on the Street: What Wall Street and Corporate America Don’t Want You to Know (Pantheon Books, 2002). Following are edited excerpts of his remarks.

What are the major challenges facing the leaders of your former agency?

In the first place, they’ve got to restore investor confidence in the accounting process. They’ve got to help upgrade and reassess the Financial Accounting Standards Board and its processes. They have to ask themselves whether reliance on U.S. GAAP alone is sufficient, or whether they need to call on international principle-based standards to go along with it. They have to very carefully reexamine the workings of the Division of Corporation Finance so that the SEC is able to examine filings more regularly.

Will the SEC tackle key regulatory issues involving analysts and rating agencies? The SEC leaders cannot allow companies to leave billions of off-balance-sheet debt out of a company’s reported liabilities. They’ve got to beef up the number of trial lawyers they have to assist their enforcement division. They’ve got to move toward a legislative change that would allow private legal actions for aiding and abetting, which are prohibited at present, to be brought against accountants and lawyers. And they’ve got to appeal for greater ability to punish wrongdoing by directors and officers. For investment companies, in particular, they have to determine better ways to motivate their independent directors to do a more comprehensive job.

Given the fact that most corporate directors are people of stature and means, why do you think the independent ones have such difficulty speaking up for the interests of shareholders as a whole?

Americans tend to operate in groups quite comfortably. And group thinking very often involves consensus. There is overwhelming social pressure to give in to the CEO, go along with management, not raise a ruckus. Chances are, the people who join boards already know other members—they may belong to the same country clubs or have attended the same schools. Of course, one’s comfort level is paramount for a person to be willing to assume the responsibility of a director’s position, but that very comfort level undermines the ability of a director to exercise independent judgment—to differ, to challenge, to question.

That’s going to change, though. At a time of pervasive corporate scandals and broad public disdain for the business community, when a number of new legal challenges to board negligence have become available, people who serve on boards are going to move away from that traditional fraternal mode.

Let’s turn to Wall Street. Assuming that, in the wake of recent legal settlements, the more egregious conflicts of interest between investment banks and their research units are cleaned up, do you think the banks will be able to provide coverage retail brokerage clients can rely on?

It’s hard for me to imagine. Let’s say that I’m an investment bank and I’m Ford’s principal banker, and I have an analyst that covers the automobile business. Until today, when Ford was doing an underwriting, my analyst made the presentation to win the underwriting deal. Starting tomorrow, my analyst can’t make the presentation. He’s walled off in another part of the firm. That’s good, but it’s difficult for me to understand how that analyst can be perceived to be objective, even though he’s writing his report in a walled-off cubicle, when he knows Ford is one of his firm’s principal clients. As long as research and corporate finance are housed under the same roof, a conflict of interest will always exist.

If brokers are expected to place with clients the securities their investment-banking colleagues underwrite, wasn’t it strangely shortsighted of top managers to allow their brokers’ credibility to erode?

You have to take into consideration that we have gone through an era where nothing was unthinkable, really, and from a commercial standpoint it did work, and it worked darn well. These analysts brought in lots of business and made lots of money for their firms and for themselves. Was it shortsighted? Depends how long you thought the game was going to run. When you’re in the middle of something like that, it’s easy to believe that your judgments are correct and the game will continue indefinitely.

Are we going to see similar types of conflicts between the commercial- and investment-banking arms at the big, new integrated financial-services companies?

Absolutely. You don’t have to look any further than the practice of tying lending decisions to the sale of other banking services. But bringing a case based on that is very difficult because the banks have refined that kind of reciprocity to a very high degree. There won’t be a contract, but there sure will be an understanding. It can be a quiet understanding, a wink. Your investment banker calls on you while you have a pending loan of some consequence and says, “Look, I know you’re casting around to do an equity deal. I’d like you to talk to our people.” That’s all it takes.

The bank would say on its own behalf, “We offer a lot of services, and obviously we want our clients to use them.’’ Call it whatever you want—it’s a quid pro quo. The banks will deny it, and the banking regulators haven’t caught it. But you’re dealing with something that I think has encouraged the creation of schemes that increase a bank’s leverage, and the schemes have obviously come pretty close to the line. I don’t think this can be solved with new laws. We need better supervision and enforcement of current laws.

Given the national scope of the securities industry, is the aggressive intervention by state officials like Eliot Spitzer, the New York state attorney general, desirable?

As a general rule, redundant regulatory jurisdictions are costly and confusing. But through the years, the commission has been happy to work with local regulators because of its own lack of resources. I think that Spitzer’s actions filled a very important need at a particular time in the history of our markets.

Was the $1.4 billion settlement Spitzer negotiated with the big banks and brokerages tough enough?

A very large part of the settlement has to be the public revelation of wrongdoing. No financial penalty would dissuade this kind of behavior without admissions of responsibility.

Both you and William Donaldson cofounded brokerages. In view of the damage done to the reputations of established brokers, would this be a good moment to start a brokerage firm?

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